As predicted three years ago, now that house prices are near the peak, for-sale inventory is returning to the market.

For home inventories to recover, sellers must come back to the market. Since so many loanowners are underwater, particularly at lower price points, very few organic sales occur on below-median properties. Further, since below-median loanowners have a strong incentive to squat until foreclosure, few of these properties are coming to market as short sales. That leaves us with a depleted market that is only be replenished by foreclosures.

Banks are in no hurry to process foreclosures and bring these properties to the MLS. To make matters worse for would-be buyers at these price points, about half of the foreclosures that are processed are being purchased by hedge funds at the auction sites. These properties are being held as rentals and not being sold on the MLS. For as much as flippers are decried, at least they sell the properties after they fix them up which adds to MLS inventories.

REO-to-rental funds keep properties off the MLS. Given these circumstances, it may be several years before inventories of below-median properties recover and provide opportunities for owner-occupants to reenter the market.

Lower-priced homes attractive to first-time buyers are in particularly scarce supply, according to a report released Thursday by real estate website Zillow.

The number of lower-priced homes available in the Golden State shrank by more than 40% over the last year, according to the analysis. Lower-priced homes were defined as those that sold for $313,200 or less. California saw the largest inventory reduction in that classification of any state.

The shortage is due to reduced bank processing of foreclosures and an increase in hedge fund and investor activity at the auction sites.

The reason is because cheaper homes — particularly foreclosed properties — have become highly attractive to investors who have developed a sophisticated industry around buying up properties, fixing them up and selling them or renting them out.

Renting out foreclosed homes has increasingly emerged as an investment opportunity to Wall Street. Financiers are busily studying ways to take the single-family home rental business, for years mostly a mom-and-pop affair, and make it a bigger industry. That has made it difficult for first-time shoppers to compete.

If not for programs from HUD (FHA foreclosures) and the GSEs that offer properties on a preferential basis to owner-occupants, very little inventory would be available to them.

“First-time home buyers are being squeezed out of the market by falling inventory and the rapid influx of investors looking to buy basic homes to rent out,” Zillow chief economist Stan Humphries said in a statement. “Investors are paying in cash and can close sooner, which is more favorable to banks and homeowners looking to sell.”

… While Wall Street has grown interested in low-end homes, real estate agents in California have bemoaned the lack of available properties for sale. Real estate professionals say the state can handle more foreclosures and they have protested plans by the federal government to sell foreclosed California properties in bulk to investors.“Sales would be even higher if inventory were less constrained … particularly in the Central Valley and Inland Empire, where there is an extreme shortage of available homes,” LeFrancis Arnold, president of the California Assn. of Realtors, said in a recent forecast distributed by the group. “Sales will be stronger in higher-priced areas, where there are more equity properties and a somewhat greater availability of homes for sale.”

The analysis by Zillow mirrored the take of the real estate agents. Central Valley markets have seen the biggest drops in supply of lower-cost homes with inventory down 59.7% in Fresno 59.7% and 55.4% in Sacramento. San Francisco supply fell 53.2%. In Los Angeles, supply was down 45.1%. Nationally, the bottom tier of homes for sale has seen a decline of about 15.3%.

Shevy relayed to me the difficulty buyers faced in the 2012 market. It was very frustrating for buyers and agents alike. There were competing offers on nearly every reasonably priced property, and even motivated buyers willing to bid above recent comps fail to obtain properties. The problems were worst at the low end of the market.

Right now, I don’t see an end to this problem. The incentive of sellers is to wait. Lenders get greater capital recovery, and some loanowners can get out at breakeven. Eventually, more organic sellers will come to the market, particularly those who are distressed, but creating organic sellers requires a significant increase in price. So until prices rebound substantially (or if the banks change their policies), the inventory shortage will persist, and it will be particularly acute at below-median price points. It’s amazing how quickly the market changed from 2011 when the same demand was greeted with 40% more inventory and competing sellers willing to slash prices.

Fast forward to 2015, and house prices are near the peak (even beyond the peak in Irvine), and as a result, for sale inventory is coming to market at a time of year when sales are falling.